Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. We note that ASVEF (MUN:UIJ) has a debt on its balance sheet. But does this debt worry shareholders?
When is debt dangerous?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. The first step when considering a company’s debt levels is to consider its cash and debt together.
See our latest analysis for AS VEF
What is AS VEF’s debt?
As you can see below, AS VEF had 2.07 million euros in debt in September 2021, compared to 2.23 million euros the previous year. On the other hand, he has €85.7k in cash, resulting in a net debt of around €1.98m.
A look at AS VEF’s liabilities
According to the last balance sheet published, AS VEF had liabilities of €191.5 K less than 12 months and liabilities of €2.20 M beyond 12 months. In return for these bonds, it had cash of €85.7K as well as receivables worth €112.3K maturing in less than 12 months. Its liabilities therefore total €2.19 million more than the combination of its cash and short-term receivables.
Given that AS VEF has a market cap of €11.8m, it’s hard to believe that these liabilities pose a big threat. But there are enough liabilities that we certainly recommend that shareholders continue to monitor the balance sheet in the future.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
A low interest coverage of 0.62x and an extremely high net debt to EBITDA ratio of 10.3 shook our confidence in AS VEF like a punch in the gut. This means that we would consider him to be heavily indebted. Worse still, AS VEF has seen its EBIT drop to 56% over the last 12 months. If earnings continue to follow this trajectory, paying off this debt will be more difficult than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when analyzing debt. But it is the results of AS VEF which will influence the holding of the balance sheet in the future. So, when considering debt, it is definitely worth looking at the earnings trend. Click here for an interactive preview.
Finally, while the taxman may love accounting profits, lenders only accept cash. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, AS VEF has produced strong free cash flow equivalent to 53% of its EBIT, which is what we expected. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
At first glance, AS VEF’s interest coverage left us hesitant about the stock, and its EBIT growth rate was no more appealing than the single empty restaurant on the busiest night of the year. But on the bright side, its conversion from EBIT to free cash flow is a good sign and makes us more optimistic. On a larger scale, it seems clear to us that AS VEF’s recourse to debt creates risks for the company. If all goes well, this should boost returns, but on the other hand, the risk of permanent capital loss is increased by debt. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example, we have identified 4 warning signs for AS VEF (2 should not be ignored) which you should be aware of.
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.